Sunday, February 12, 2012

Stocks: you can fondle them and they might put rohypnol in your drink and steal your wallet. A comment on Warren Buffett's recent fortune piece.

Warren Buffett recently wrote an article in Fortune (a cut from his forthcoming shareholder letter) which explains why he prefers owning businesses (either outright or through the stock market) than owning currency based investments (bonds, cash) or gold.

Buffett's writing and thinking is a model of clarity. Kid Dynamite's highlighting and analysis is a worthy follow-up.

Buffett does not like bonds or cash as investments because they are (in his view) unlikely to retain their real value over the medium to long term. In God we Trust - but the hand that activates the printing press is human. Buffett defines investment return in real goods and services - investment is putting away some spending power now in the expectation of having more spending power later. Bonds and cash make nominal returns. Buffett thinks real returns are unlikely and disastrous outcomes are possible: "[currency based investments] are among the most dangerous of assets. Their beta may be zero, but their risk is huge".

Quoting Shelby Davis he notes that at current yields currency based investments offer return free risk.

Though unstated you can tell Buffett does not predict a Japanese outcome. Twenty years of deflation would make bonds a fantastic investment by Buffett's criteria. That is a possibility he does not even entertain...

Buffett is not fond of gold either - waxing lyrical on its uselessness. The world gold stock if melded together would fit in what he views as a useless 68 foot cube. Think of it as sitting comfortably in a baseball infield.

And he notes the extraordinary value of that cube. At current prices that cube would buy all the agricultural land in the United States, sixteen companies as valuable as Exxon and leave you a trillion dollars in walking-around money. He cannot imagine why you would prefer own the cube than the alternative assets. Similarly he can't imagine why you would want to own a bit of that cube than an equivalent bit of the alternative assets.

Over the next century 16 companies as valuable as Exxon will have thrown of trillions in dividends - and the agricultural land will have thrown off huge quantities of wheat, corn, beef and other valuable commodities.

The gold will just sit there.

The best line in the article is one of Buffett's sexual zingers: you can fondle the cube, but it will not respond.

He is right of course. Some people think that gold is a good investment because it has retained its value (measured in agricultural land) for centuries. That is all the proof you need that the investment is stupid. The agricultural land had a yield all that time. The gold probably got stolen - and had no yield.

Buffett's prescription: own productive assets.

And that is good advice if you pick productive assets with competence. If you don't I think the Buffett prescription can be a recipe for disaster.

You see the gold does not have free-will - or any will for that matter. Fondle it and it does not respond.

Stocks and businesses however have people running them - and people range from clever to inanely stupid. Integrity levels cover the spectrum from someone you would hope would marry your daughter to Bernie Madoff.

Willie Sutton robbed banks because that is where the money was. Now the money is on Wall Street. If Willie Sutton was reincarnated he would come back as some Wall Street scumbag (or an investment banker). And on Wall Street he would almost certainly not be prosecuted. People who rob banks get prosecuted. People who steal via the stock market not so much.

Because the scumbags go where the money is Wall Street is particularly thick with scumbags. Wall Street has tens of thousands of Willie Suttons.

Fondling stocks can be very profitable if you know what you are doing - especially over very long time periods. But the proviso is there ... if you know what you are doing.

And gold is pretty easy to understand. It just sits there. People however are difficult to understand and sometimes dangerous - and people and the stock market are intertwined. And you are more likely to find a scumbag in the stock market than internet dating (the scumbags have Willie Sutton motives).

If you do not know what you are doing fondling stocks can be either as much fun or as dangerous as fondling people. Some may respond by being nice back. Some will spike your drink, lift you wallet and sodomize you on the way out.

Mr Buffett makes it seem simple. I love reading him - but sometimes I think he is dangerous because he makes it seem so easy that it lulls people into a false sense of security...

John

PS. Positions: no gold. Long companies with high levels of management integrity and decent valuations. Short scumbags, slimeballs and villains. Names can be left out of this piece.

23 comments:

Anonymous
said...

Very astute points and caveats. And the data support it as well as the twice-in-a-decade-burnt boomers and long suffering in the Nikkie would attest to. As antii ilmanen points out in his expected returns, the problem with stocks is dual fold: steep drawdowns when you can least afford it, thus risking permanent loss in capital. Coupled with the excess allocation of capital to classes after bull and bear markets, and stocks are surely dangerous if you don't know what to do and not know what u don't know. And even those exclude the irrationality and passions investors have at market extremes.

*Most, but not necessarily all, people invest with the primary goal of improving rather than retaining existing purchasing power. However, some people may be satisfied with the retention of existing purchasing power alone - particularly those with large savings who are not particularly savvy investors.

Gold may have some merit here. However, one is still taking substantial risk of loss of purchasing power atm given the large run-up in prices that has now occurred to levels well above replacement cost.

Also, real estate (espcially unlevered real estate) probably plays a better role in this respect. Unlevered real estate is a great hedge against inflation, will always have value, and also produces a positive yield. Overpayment is a risk of course, but that risk is probably less than that of gold today - even in relatively frothy real estate markets.

*The other observations is this - Buffett's disdane of fixed interest investments stems from the premise that nominal interest rates do not adequately compensate investors for inflation risk. One could argue that the flip side of this argument is that it may be sensible to go into debt so some manageable extent to finance the purchase of productive assets (on the premise that the inflation "tax" on debt owners is a corresponding non-taxable inflation "rebate" to people that owe debtt).

Much (though certainly not all) of the profits in real estate have arguably come from the devaluation of these real value of real estate mortgages rather than an increase in the real value of real estate.

PS re your comments on deflation - yes indeed - if buffett can be potentilly faulted at all, one possiblity would be that he doesn't understand credit cycles that well. He has only lived and invested through a secular increase in credit & money supply, and never through a deflationary credit contractionary period. So he is at risk of being blindsided by a changed paradigm here.

This may be one reason he dismisses/overlooks the Japanese experience. The other is that he has faith (rightly or wrongly) that Bernanke et al will ensure that a multi-decade deflation will not occur.

The truth is that inflation (or the lack thereof) is largely a political decisions & buffett recognises this.

Please compare Warren's current deliberation on gold with this excerpt below from his 1979 letter when he was battling inflation. Judging by this excerpt, inflation looked like a nasty bout of syphilis one gets after fondling "productive assets".

Excerpt:

Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance, purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.

If we should continue to achieve a 20% compounded gain - not an easy or certain result by any means - and this gain is translated into a corresponding increase in the market value of Berkshire Hathaway stock as it has been over the last fifteen years, your after-tax purchasing power gain is likely to be very close to zero at a 14% inflation rate. Most of the remaining six percentage points will go for income tax any time you wish to convert your twenty percentage points of nominal annual gain into cash.

That combination - the inflation rate plus the percentage of capital that must be paid by the owner to transfer into his own pocket the annual earnings achieved by the business (i.e., ordinary income tax on dividends and capital gains tax on retained earnings) - can be thought of as an “investor’s misery index”. When this index exceeds the rate of return earned on equity by the business, the investor’s purchasing power (real capital) shrinks even though he consumes nothing at all. We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.

If you had bought the DJIA exactly 10 years ago at 9744.24 for a 31.37% gain you're REAL decade's gain once you account for the fact that your 2002 USD is worth 80c today (per BLS) would be a dismal 5% (or 0.5% annualised returns)?

Not many companies pay regular dividends anymore but granted accounting for reinvestment would make your annualised returns more like 1-2%.

I think your spot on to describe Buffet's advice as dangerous, unless you are a major political insider/crony like him or a full time, well equiped investor like yourself I think one should stay the hell away from stocks which are a major destroyer of wealth for ordinary folk.

Buffet might claim risk comes from not knowing what you're doing but clearly he fills this gap in his knowledge through cronyism, you & others like you fill it through extensive research but the ordinary investor has no chance to compete.

Gold on the other hand is up from $300.3 to $1729.1 in the same time frame, an absolute REAL return of 460% and an annualised real return of 18.79%.

Had a retired investor 10 years ago parked their assets in cash (simple term deposits) and gold they'd be eating Filet Mignon on the beach, had they parked it in stocks they'd be eating cat food in a housing commission slum, quite literally this unlucky retiree would be 1. starving or 2. burning through their capital like it's firewood.

In my view some cash for the sake of liquidity and some gold as the only inflation hedge that can't be printed/diluted (and indeed gold is the only asset that isn't someone else's liability) are two genuinely safe assets for the ordinary investor today. Stock's are a pure risk/speclative asset unless you're a specialist or crony.

Any idiot could buy stocks like Buffett. What he has that most people don't is political connections.

His father was a Congressman. Ben Graham rejected Buffett working for him, not even for free.

Buffett got a free pass for Solomon Bros, GenRe, the accounting scandal at Coca-Cola, the earnings manipulation and accounting scandals at FNMA, and the insider trading scandal at Berkshire Hathaway itself that led to Sokol resigning (Buffett still denies his involvement in the cover up).

Buffett was told by Geithner to hurry up and extort 10% cumulative preferred shares out of GE and Goldman Sachs -- deals that were not offered to employees nor existing shareholders. Two days later, the crook Geithner announced unlimited taxpayer loans for both firms at ZERO percent.

Buffett makes his money from political connections, not stock picking.

yeah but stupid he is, does he not know that the same crooks that ran the banking system , also runs wallstreet which is manipulated . I scalp stocks for quick cash to buy hard assets yes that is also gold , stocks are merly nothing but a paper asset and I promise you all paper assets will fail ,and I can go mall over the world and exchande my little piece of cube for any goods I want, I can buy more with my hard asset than the paper funny money can thats why you hold gold its a world currency try trading a stock certifacte for gas , or any good for that matter who wants paper , thats just it dumb ass buffet who agrees with obama adminastation on everything, he dont own farmland or ten exons he owns paper assetes, he really dont have nothing but one big hipercrte

Yes there are some scumbags on Wall St - but not every management team is laden with scum bags - they are the exception - not the rule. If you are worried about management in a few companies - simple - buy the index. Warren's point is - buy stocks - not gold. To calculate the compound rate for gold over the last 10 or 20 years is rediculous. I mean, we are in one of the biggest gold bull markets in the last 100 years. The question you should be asking yourself is, will the next 10 years in gold look like the last 10 years? I seriously doubt it. I'm sure some people will jump down my throat on this point - before you respond - spend a few minutes on the tulip mania, tech bubble or south sea bubble. What the wise do in the beginning, the fool does in the end! Think about it!

"Positions: no gold. Long companies with high levels of management integrity and decent valuations. Short scumbags, slimeballs and villains. Names can be left out of this piece."

John, that's what you think.... might be all the way around in the end - owning scumbags, shorting decent valuations. Dangerous indeed. I assume you believe you understand the equity game. And, as you mentioned "gold is easy to understand", I assume you believe you understand gold even better than equities. You do not hold gold, thus you believe that, as of now, owning equities is more profitable than owning gold. Here, you are in the same boat with Mr. Buffett. That would be interesting to check in a year or two....

Anonymous wrote: Ben Graham rejected Buffett working for him, not even for free.

At the time, all the major Wall Street firms refused to hire Jews, and Graham was a Jew. So Graham reserved employee spots at his firm for other Jews, and Buffett is not a Jew. Eventually, Graham relented and hired Buffett as the first non-Jewish employee.

Anyway, gold is something people have always wanted to buy in the past, for whatever psychological reasons, and this is no reason to expect people to change in the future. Owning gold or gold miners is thus no more crazy than owning Tiffany's or Borsheims (the jewelry company owned outright by BRK) or the Coca-cola company, or Wrigley's gum company, etc. Some types of deeply seated human preferences are stable over long periods of time.

The real problem with all assets is pricing them. The price of KO is only partly based on dividends for the next few years, which can be reliably forecasted. Rather, most of the price reflects dividends far into the future. Who is to say that people won't tire someday of Cokes sugar-water-phosphic acid concoctions that eat away at tooth enamel, cause caffeine withdrawal symptoms if you ever stop drinking them, and make you fat to boot? Is that any more unlikely than people tiring of gold? And when will people tire of Coke and how slow will the decline be? Or perhaps Coke won't decline but rather will become even more popular. Or perhaps there will be a lawsuit against KO and the company goes bankrupt. You can't call buying KO stock entirely rational in the face of all these unknowns about the future. At today's prices, buying KO is just as much a gamble as buying gold at today's prices.

The only rational course of action for the long-term oriented investor is to diversify widely, and gold should be part of such a rational policy of diversification.

I've read all (or nearly all; some several times) Warren Buffett's letters. Suffice it to say, I used to be a fan + admirer.

I appreciate that you give off a nuanced perspective on Buffett. The vast majority of people who opine on Buffett either despise him on one hand, while others treat him as if he were the second coming of the Messiah, the Mahdi. Many of these comments in response to this post are a case in point.

(1) I respect Buffett...nothing more, nothing less, just as an aspiring athlete respects the superstars of yesterday.

(2) I find greater actionable insight by studying Buffett's words vs. actions throughout the years. For example: Buffett was NOTABLY (and intentionally) MIA from public equity investing for a good chunk of the 1970s.

(3) Buffett has shared his knowledge + experiences freely to the public. His insights are more valuable than a CFA + MBA combined, in my opinion, for money managers. Critics should seriously weigh his positive contributions against their (largely) valid concerns.

(4) Buffett's exceptional ability to select great businesses from the massive cemetary of losers, is an additional reason his prescription - to own productive assets (e.g. stocks) - is especially dangerous. The "look at me, I can do it!" does NOT mean "So can I!"

The Buffett worshippers would therefore be wise to take his recommendations with a grain of salt, i.e. he's a better stock picker than the rest of us!

(5) The descriptive vs. the prescriptive - I personally find some of the more concretely helpful material coming from Buffett's description on how the world works (or doesn't), rather than his advice on what you should do.

(6) Buffett is fallible. He's said so many times, if I recall correctly. He too can lie, contradict himself and be wrong.

(7) Context matters - Buffett's AUM has risen with time, as has his strategy, to adapt. This is just one example of why it's important to take Buffett's words in the context he wrote/said them. Many (amateur) Buffett lovers treat his words as absolute, context-independent truths; his haters unfairly take his words out of context. Both miss out on the opportunity to learn and grow.

In this article (and other commentary at the time), Buffett was actively warning investors that they were expecting far too much from stocks, and that stocks were dangerously overpriced at current levels - especially tech stocks.

Criticism was heaped on Buffett at the time for being too bearish on stocks, and tech in particular. The old-timer had lost his touch and was out of beat with the new economy, so the critics said....

The criticisms of Buffett today are almost identical in nature - bashing the guy because his advice about what to do TODAY, would not have worked over the past 10 years under very different valuation starting points. And yet few sound arguments refuting the logic of his arguments is proffered. Its amateur stuff.

Buffett's warning against owning gold today is based on today's price of US$1,600, not the price 10 years ago of US$300. His warning against buying bonds is based on today's yield. Much like his warning against owning stocks 10 years ago was based on their pricing at the time.

And despite all the attacks, where is the refutation of his key point, that you are likely to be much better off owning all of the agricultural land in the US, and 17Exxon Mobils, than a hunk of rare metal? Where is the refutation of the fact that US$160bn in new gold production each year has to be absorbed by the market to sustain the current price?

If you think that owning stocks or companies gives you ownership rights which will not be taken away, then Mr. Buffett is right. His commentary reveals his blind spot--go ask anyone in Russia (for example) if they think that ownership of stock means control of a company and its productive assets. People own gold because they can hold it close. I sure that Buffett, who has been raised and ripened in our polite form of capitalism, doesn't worry about confiscation, but there are those who do, and to lecture them on their naivete is sophmorific.

Quite a bit of good thinking here, but also quite a few based on data mining. All the "if you did X instead of Y you would have received returns of Z" thinking is rather dangerous. It gives you a false sense of hope that you can figure out how the future will pan out. Specifically someone mentioned real estate. That's a reasonable asset to hold most of the time as part of diversification, but you do need rents to maintain the capital and return a yield. These rents and any capital appreciation resulting from these rents, are determined by population dynamics that we poorly understand.

Take New York City. A long term holding period of a Manhattan apartment would have done quite differently depending on whether people subsequently wanted to live in the suburbs or if urban living was attractive.

NYC is of course anything but an average city. Predicting demographics, credit conditions, cultural changes, job market changes and future population patterns is a risky endeavor.

A point has been lost in agreeing with Buffet's sentiment, but disagreeing with its universal aplication:

BUFFETT IS NOT GIVING RECOMMENDATIONS. HE IS SPEAKING TO HIS OWN PREFERENCE.

Obviously, few will match Buffett's stock selcting success, but thats not the point. Its horses for courses - like everything in life, and he is simply talking about the logical merits of his own course.

He makes no attemppt to argue that the course is necessarily suited for every other horse. Buffet would be the first to agree that stocks require great care and expertise. And his article implies nothing less.

Buffett is reflecting on his own success, and to the extent that we can gain insight from it, he is to be respected for his generoisity of thought. But there really is no basis for "disagreeing with his advice", becuase that would misunderstand the explicit premise of his peice.

The comments from the Buffett-haters about him relying on crony capitalism are beyond stupid.

Let's see - at what point in his FORTY YEAR track record of compounding at 20%+ did he begin to benefit from "cronyism". Was it from the very beginning when he was a one man show in an office just off the bedroom in his rented house in the middle of nowhere?

Does he have connections because of his track record, or does he have his track record because of his connections?

Here's what the fools don't get.Buffett is the greatest learning machine in history. He is unbelievably obsessed with acquiring and analyzing new information. I have met him. In the two days prior to meeting him he had read two entire books in addition to consuming his normal intake of 5 daily newspapers and various data from Berkshire's many business units.

He is so smart it's virtually impossible to engage with him on his level. There's almost nothing you can talk about that he hasn't thought about so thoroughly he isn't already 12 moves ahead.

"But What do I Know?" criticizes Buffett's "blind spot" with regard to ownership rights in Russia.

Yet Buffett has previously discussed this exact subject. Around the time that he started Petrochina, he had the opportunity to buy stock in a Russian oil company instead. He decided that he trusted the Chinese more.

And he was right. He got paid every penny of the promised dividends, and on top of that, cashed out for an enormous capital gain.

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The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.